By Paul J. Davies and Sam Goldfarb
The Federal Reserve Bank of New York saw huge demand from banks
Wednesday morning, as they rushed to bid on the $75 billion on
offer in a second day of intervention to ease a crunch in overnight
funding markets.
Banks bid for $80.05 billion in funding in the auction -- $5
billion above the maximum amount offered by the Fed. Tuesday's
auction, the first in a decade, saw banks take $53 billion of the
$75 billion on offer. Overnight rates remained elevated before
Wednesday's auction at about 2.8%. Soon after, it dropped to 2.6%
and by midmorning was down to 2.25%, according to Refinitiv
data.
The tumult in U.S. overnight money markets is adding to
investors' hopes that the Federal Reserve might cut rates faster
than expected in coming months or restart bond buying to boost the
amount of money in the financial system.
A loosening of monetary policy could alleviate the strains that
caused overnight lending rates to spike as high as 10% Tuesday. The
Fed is set to conclude a two-day policy meeting Wednesday, after
which it is expected to cut its benchmark interest rate by a
quarter-percentage point.
The high short-term U.S. rates and lower rates elsewhere have
put foreign investors off buying Treasurys as it becomes
increasingly less profitable to fund longer-term U.S. government
bonds with short-term borrowing.
"A series of sharper than priced in rate cuts from the Fed will
bring down the front end of the yield curve [cut short-term yields]
and encourage foreign buyers back in," said Guy LeBas, chief
fixed-income strategist at Janney Capital Management, in
Philadelphia.
Foreign buyers with lots of dollars at hand, such as non-U.S.
lenders and central banks, have also stopped buying Treasurys
because they can put unlimited amounts of cash into the Federal
Reserve's foreign repo program. This facility is an ultrasafe haven
for funds -- paying the same as overnight repo -- and has been
absorbing foreign-owned dollars like "a supermassive black hole,"
Zoltan Pozsar, a money-market strategist at Credit Suisse Group,
said in August.
Cutting interest rates more rapidly so that longer-term
Treasurys yield more than short-term money would help to reverse
this trend.
The spike in overnight rates has already had some impact on the
real economy.
By Tuesday morning, the rate of borrowing money in the
repurchase-agreement, or repo, market reached as high as 10%,
compared with just over 2% in the days prior. The Fed's effective
benchmark rate traded at 2.3% on Tuesday, according to the New York
Fed, above the 2% to 2.25% target set by the central bank's
rate-setting committee. This hasn't occurred since the Fed moved to
a target range after the 2008 financial crisis.
Evergy Inc., the holding company for several utilities in Kansas
and Missouri, saw overnight rates for its commercial paper almost
double, according to the company's assistant treasurer, James
Gilligan. The rates rose from 2.3% to 4.5% and from 2.34% to 4.05%,
while rates for six-day commercial paper increased from 2.3% to
2.6%, Mr. Gilligan said.
The company's entities usually borrow $20 million to $100
million each through commercial paper each day. Mr. Gilligan said
he is expecting more rate spikes going forward.
But the bigger problem is in the balance sheets of U.S. banks,
particularly those that act as primary dealers, the institutions
that buy Treasurys from the government and sell them on to
investors.
The spike in overnight repo rates was caused by a string of
coincidental events, including corporate tax payments and Treasury
sales, according to analysts and investors. But those events only
had such a startling effect because banks were already operating
close to the minimum level of reserves they want to hold.
After the 2008 crisis, the Fed's massive bond-buying programs
led to a huge increase in reserves in the system. But that has gone
into reverse as the central bank tightened monetary policy in the
past couple of years.
The Fed's reversal has forced the U.S. Treasury to sell more
bonds to banks and investors. That reduces the amount of money in
the financial system because primary dealers buy the bonds using
reserves.
The Fed believed there was still spare capacity of $200 billion
to $300 billion in reserves before money would get too tight and
overnight funding problems would appear, according to Morgan
Stanley analysts. However, the combination in recent days of
corporate tax payments and Treasury issuance showed that cushion
may not have existed.
"Ultimately, the only way for the Fed to alleviate reserve
scarcity and funding stress is to inject liquidity and increase the
amount of reserves in the system," the analysts wrote in a note
published overnight Tuesday.
This is why New York poured billions in overnight funding into
the repo market on Tuesday and again on Wednesday.
Some think the Fed will keep plugging gaps using operations like
these rather than pushing through faster rate cuts or restarting
bond buying. Market glitches and supporting the economy are "two
separate tracks in the Fed's mind," said Blake Gwinn, a rates
strategist at NatWest Markets.
But a longer-term solution will be needed. One problem for the
Fed is that it has become more difficult to know just how much
reserves banks want to hold. This is due to changes in regulations
designed to ensure banks can meet waves of deposit withdrawals in
times of extreme stress.
"Market participants are now asking: 'Is the Fed up to the task
of estimating the quantity of reserves required by banks and
whether it has the tools to supply them when needed'," said Mark
Cabana, head of U.S. short rates strategy at Bank of America
Merrill Lynch in New York.
"They [the Fed] don't understand the impact of some of the
second-order effects of regulations they've put in place since the
crisis," he said.
--Nina Trentmann, Justin Baer and Patricia Minczeski contributed
to this article.
Write to Paul J. Davies at paul.davies@wsj.com and Sam Goldfarb
at sam.goldfarb@wsj.com
(END) Dow Jones Newswires
September 18, 2019 11:36 ET (15:36 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.